I am an attorney (www.lewissaret.com) practicing in the area of federal taxation, with particular emphasis on estate and business succession planning, based in the Washington DC metropolitan area. In addition, I am Chair and former Vice-Chair of the Fiduciary Income Tax Committee of the American Bar Association Section of Taxation. In the past, I have also served as Vice-Chair or Chair on a number of committees including the Asset Protection Planning Committee of the Real Property, Probate and Trust Section of the ABA. I am a prolific author and frequent speaker on tax and estate planning issues, co-authoring numerous books including Asset Protection Strategies: Tax and Legal Aspects and Valuation of Closely HeldBusinesses: Tax and Legal Aspects. I am also the co-founder of the Wealth Strategies Journal, an online journal pioneering to provide quality wealth management guidance available to the general public.

Material Participation of Trusts And Estates: Trustee Material Participation As A Fiduciary

After the Mattie K. Carter case, the IRS issued three technical advice memorandums (“TAMs”), which addressed specific determinations of material participation for trusts and estates. This post summarizes the third and most recent TAM, which deals with the position of the IRS in regards to determining material participation based on the specific actions of the trust or estate’s fiduciary.

TAM 201317010

Facts. In TAM 201317010, two identical trusts, Trust A and B (the “Trusts”) were created on the same date. Each Trust owned an interest in Company X, which was an S corporation. Company X wholly owned Company Y, a qualified subchapter S subsidiary.

B was the sole trustee of the Trusts since their creation. A, who also owned the interests in Company X not owned by the Trusts, was designated as special trustee and served in this capacity since the creation of the trusts. Article XI of the trust agreements, which appoints A as a special trustee of the Trusts, stated that:

[t]he Special Trustee shall control the following activities relating to Company X and Company Y common stock owned by any trust created hereunder: all decisions regarding the sale or retention of such stock and all voting of such stock.

The trust agreements did not grant any further fiduciary powers over the Trusts’ assets or with respect to the operations or management of the Trusts to A as the Special Trustee.

A also served as president of Company Y and, as such, was directly involved in the day-to-day operations of its trade or business activities.

TAM 201317010 stated that A was unable to differentiate his time spent as president of Company Y, as Special Trustee of the Trusts, and as a shareholder of Company X.

B, as Trustee of Trust A and Trust B, was not involved in the operations of the relevant activities of either Company X or Company Y on a regular, continuous and substantial basis.

Legal Issues Presented. The IRS asserted that the Trusts did not materially participate in the relevant activities of Company X. Specifically, the IRS asserted that B’s participation in the relevant activities of Company X and Company Y that counts towards meeting the material participation requirements of Code Secs. 56(b)(2)(D) and 469(h)(1) is only that which was performed in the relevant activities in B’s fiduciary capacity as Trustee of Trust A and Trust B. In addition, the IRS asserted that A’s participation in the relevant activities of Company X and Company Y also count towards these requirements, but only to the extent that A participated in those activities in A’s fiduciary capacity as Special Trustee of Trust A and Trust B.

The IRS asserted that A’s time spent serving as president of Company Y did not count towards meeting the material participation requirement because A was not the Trustee of the Trusts nor was A an employee of the Trustee. Specifically, because the trust agreements limited the powers of the Special Trustee to certain delineated acts, the Special Trustee did not possess broad or unlimited discretionary authority to bind the Trusts to any course of action without the express consent of the Trustee.

In making this assertion, the IRS rejected the taxpayer’s argument that, because A was a Special Trustee, his involvement in Company Y’s relevant activities should be considered for purposes of determining whether the Trusts materially participate.

The IRS also rejected the taxpayer’s argument that because A’s roles of Special Trustee, individual shareholder, and President of Company Y were all interrelated, it was impossible to differentiate A’s time into the different capacities for which A serves and that A was, in fact, fulfilling A’s obligations for these various capacities simultaneously and, therefore, A’s total time spent involved in the operations of the relevant activities of Company X and Company Y should count towards meeting the material participation requirements.

Ruling and Analysis. In TAM 201317010, the IRS ruled that the Trusts did not materially participate in the relevant activities of Company X or Company Y.

In reaching its ruling, the IRS again rejected the holding of the Mattie K. Carter Trust case and instead stated that it believed that the standard annunciated in the legislative history is the proper standard to apply to trusts for material participation purposes under Code Sec. 469(h). As a result, it explicitly stated that “the sole means for Trust A and Trust B to establish material participation in the relevant activities of Company X and Company Y is if the fiduciaries, in their capacities as fiduciaries, are involved in the operations of the relevant activities of Company X and Company Y on a regular, continuous, and substantial basis (emphasis added).”

Concerning the special trustee, the IRS stated, consistent with TAM 200733023, that a fiduciary must be vested with some degree of discretionary power to act on behalf of the trust, citing to J.H. Anderson. Here, it noted that while A was involved in the day-to-day operations and management decisions of Company X and Company Y, A’s powers as Special Trustee were restricted by Article XI of the trust agreements. As Special Trustee, A lacked the power to commit the trusts to any course of action or control trust property beyond selling or voting the stock of Company X or Company Y. The work performed by A was as an employee of Company Y and not in A’s role as a fiduciary of the Trusts and, therefore, did not count for purposes of determining whether the Trusts materially participated in the trade or business activities of Company X and Company Y under Code Sec. 469(h).

The IRS noted that A’s time spent serving as Special Trustee voting the stock of Company X or Company Y or considering sales of stock in either company would count for purposes of determining the Trusts’ material participation. However, in this case, A’s time spent performing those specific functions did not rise to the level of being “regular, continuous, and substantial” within the meaning of Code Sec. 469(h)(1). Trust A and Trust B represent that B, acting as Trustee, did not participate in the day-to-day operations of the relevant activities of Company X or Company Y.

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